Previously, we discussed the maximum payment you can receive from a Defined Benefit Plan. In this post, rather than focusing on the maximum payout or “lifetime limit”, we will explain the maximum annual contribution. Additionally, contributions in Defined Benefit Plans (“DB Plans”) are not discretionary. In general, contributions are required each year. This annual minimum contribution along with the maximum deductible contribution constitutes the Defined Benefit contribution range.
As mentioned, Defined Benefit Plans have an annual contribution requirement. The required contribution depends on how well funded the plan is and how much benefits increase during the year. The contribution timing also affects the requirement.
Before going further, we need to explain a couple of terms. First, Plan Assets are the assets set aside to fund Defined Benefit Plan benefits. Assets are not held in individual accounts. Rather, assets for all employees in the Defined Benefit Plan are pooled and are used to fund everyone’s benefit in the Plan. Second, Plan Liability is a measure of the amount needed today to fund current benefits. (As an aside, for required contribution purposes, Plan Liability uses interest rates that currently are artificially higher than market rates).
Now that we have those terms out of the way, let’s explain how the minimum required contribution works. First, if Defined Benefit Plan benefits increase, the full value of those increases must be funded. Second, when Plan Liabilities exceed Plan Assets, that deficit is amortized over 15 years. On the other hand, if Plan Assets exceed Plan Liabilities, that surplus reduces the value of benefit increases that must be funded. Confused? Let’s look at two examples using simple numbers.
Let’s assume the value of benefit increases is $20, the Plan Liability is $100 and Plan Assets are $80.
In this situation, the Defined Benefit Plan is underfunded since the Plan Liability of $100 exceeds the Plan Assets of $80. This underfunded amount needs to be amortized over 15 years. If the 15-year amortization of the unfunded is $2 per year, then the required contribution would be $22 ($20 for the value of benefit increases + $2 amortization). In the following year, the required contribution is recalculated on the updated components.
In practice, these calculations are more complicated. For example, Plan Assets may be smoothed, the calculation of the Plan Liability can be complicated, and the amortization amount adjusts for outstanding amortization “bases” established in prior years. The purpose of this example is simply to show how this works at a high level.
For our second example, let’s assume the value of benefit increases is $20, the Plan Liability is $100 and Plan Assets are $110.
In this situation, the Defined Benefit Plan is overfunded since the Plan Assets of $110 exceed the Plan Liability of $100. Therefore, no amortization of underfunded liability is required. Instead, the surplus of $10 ($110 less $100) is used to reduce the value of benefit increases of $20. This would result in a required contribution of $10 ($20 less $10).
In this example, if the surplus exceeded the value of benefit increases, the required contribution would be zero.
The required contribution also is adjusted for interest. Thus, the requirement increases as time passes. The rate of increase is somewhat technical and depends on a number of factors. However, in today’s environment, the interest adjustment for timely contributions is about 5% to 6% per year.
With the required contribution under our belt, we turn to the second half of the Defined Benefit contribution range – the maximum deductible contribution.
Like the required contribution, the maximum contribution funds the full value of benefit increases. However, unlike the required contribution where unfunded amounts are amortized over 15 years, the maximum contribution allows the employer to instantly fund 150% of the Plan Liability. Moreover, the employer can immediately fund any increase in Plan Liability due to expected pay growth. As you can see, this calculation allows for massive contributions. In fact, if fully utilized, it may not be long before the “lifetime” limit is reached and additional contributions are not allowed.
Again, note that this explanation is simplified. For example, the maximum may be reduced when highly-paid employees have received recent benefit enhancements.
Let’s run through an example using simple figures.
For our example, let’s assume the value of benefit increases is $20, the Plan Liability is $100 and Plan Assets are $110. Further, assume the Plan Liability reflecting future salary increases is $125.
In this example, you would start with $20 (value of benefit increases). Next, you would determine the amount needed such that Plan Assets are 150% of the Plan Liability. For this example, that would be $40 ($100 Plan Liability times 150% minus $110 Plan Assets). Finally, you would add the additional $25 increase in Plan Liability due to expected future salary increases ($125 Plan Liability with future salary increases less $100 Plan Liability not reflecting future salary increases).
The total amount would be $85 ($20 + $40 + $25). This is compared to $10 in our second minimum required example, which used the same numbers. In reality, the gap would be wider between the minimum and maximum contributions, since a different interest rate basis is used for the respective Plan Liabilities.
Maximum contributions are not adjusted for interest like minimum required contributions.
An employer may deposit a contribution to the Defined Benefit Plan in the Defined Benefit contribution range. The minimum and maximum contributions constitute the bottom and top ends of the range.
The Defined Benefit Plan contribution range changes each year as the components of the calculations change. For example, in a subsequent year, Plan Assets will reflect contributions deposited, amounts paid out to employees in the Plan, and investment returns. Plan Liabilities and the value of benefit increases also will change to reflect a number of factors.
The dynamic nature of these components results in a contribution range that varies from year to year. As a result, employers who adopt Defined Benefit Plans need to be able to handle contribution fluctuations.
Consideration also must be given regarding the Defined Benefit Plan design and how Plan Assets are invested.
Finally, the Defined Benefit Plan design may be modified to reduce or increase contributions under certain conditions. Good communication between the employer, the TPA, and the Enrolled Actuary ensures the Defined Benefit Plan can be amended before it is too late.